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CHRONIC INVESTORBLOG

It is difficult to know when you are inside a bubble, and you only know for sure that you were in one when it has burst. But a number of data points from the New York Stock Exchange that have been highlighted by the inimitable Tyler Durden at Zero Hedge are making the stock market rally look a lot like a large hollow sphere with a thin iridescent soapy surface that is becoming increasingly unstable and ultimately prone to collapse as it grows.

The first problem is debt, not the massive amounts we all know about on bank balance sheets some of which is probably worthless, but the huge amount that is now being ploughed into the markets. The NYSE reported that margin debt - the amount that speculators borrow to buy stocks (or any other assets like gold) - has just reached a five-year high at $327bn (£201bn).

Putting that into perspective that exceeds levels during the 2001 dot com boom, and is just shy of the levels pre-Northern Rock collapse in 2007, those halcyon days when markets only went in one direction, up.

And this leverage isn't being used to take balanced positions. The S&P 500 e-mini futures contract - the most liquid equity trading vehicle in the world - now stands at its most net-long position since December 2008. That means a lot of people with a lot of debt are betting on the markets going higher.

Then there is the VIX index - the implied volatility of S&P 500 index options, or the markets' 'fear guage' - that is reaching new lows, or more specifically the VIX Futures: Net Non-Commercial position - futures based on the VIX that are popular instruments with hedge funds and banks to take speculative positions.

This should be a good sign as lower fear equals higher confidence right? Wrong. Here we hand over to the guys at Zero Hedge who think something fishy is going on: "What changed in June? Well, as some may recall, something very substantial - the head of the Fed's Markets Group (it's trading desk), got a new head, Simon Potter, who has been rumoured to have a different style to his predecessor Brian Sack. His style involves the relentless selling of VIX to take advantage of a market which is drowning in reflexivity (the theory of reflexivity states that investors and traders biases can change the fundamentals that assist in determining market prices) and in which the movement of the volatility surface has a far greater impact on the underlying asset than any fundamentals or news flow. Namely, if you want to send the market higher (and have an infinite balance sheet at JV partner Citadel courtesy of your backstop) then just sell, sell, sell VIX."

Does all this mean we are heading for another crash? Well no. But what it does show is that investors are using similar amounts of leverage in markets than before previous crashes. This is all fine if the markets carry on rising. But if the markets fall, even a little bit, the phone starts ringing with a dreaded margin call. If investors don't have the cash to cover the margin call in the asset in which they are invested, then they have to close the position, or close another more liquid position to raise the necessary cash. This can very rapidly create a nasty negative feedback loop.

The net long weighting in the equity market means that if the market falls it is more painful because the short position which would offset losses is much smaller. That hurts, and could lead to rapid wholesale closing of long positions, which on thin volumes doesn't take much to lead to a panic.

Finally the VIX manipulation, if Zero Hedge are right, is even more sinister. The VIX should fall and equity markets rise when fundamental conditions improve in the economy, that is the theory. If the Federal Reserve are selling VIX they are effectively putting the cart before the horse and trying to persuade the markets everything is ok, despite the all too apparent backdrop of general economic malaise. I would imagine this is based on some warped 'Friedmanite' economic thinking that the wealth effect from the markets will prompt the long awaited economic recovery. I wouldn't bet on it.

So what should long-term value investors do, other than reach for the bottle in despair. Well keep an eye on any high beta stocks - think cyclicals like equipment rental, distributors, industrials - as they will rocket but come crashing down just as fast if we get a correction. Above all stick to your core investment philosophy whatever that may be, don't be tempted to deviate by the allure of returns, more likely than not your timing will be wrong and losses will follow.

John Ficenec

John Ficenec is Companies Writer having previously qualified as a chartered accountant before working in asset management and private equity. He covers Support Services and Utilities sectors including recruitment, outsourcing, distribution, water and power.

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